Emerging Markets Barrel Ahead Despite Tightening Fed

Emerging markets, long vulnerable to the whims of central banks in the developed world, now seem to be more Fed-proof than ever.

The Federal Reserve is set to raise interest rates for the third time this year Wednesday, just as other central banks in the developed world have recently started to tighten monetary policy. But investors in developing countries aren't flinching, reflecting confidence in the growing global economy and a changing investment landscape in those countries, fund managers say.

"Everybody used to think if the Fed tightens, all emerging markets die," said Helen Qiao, managing director at Bank of America Merrill Lynch in Hong Kong. "I don't think that is the picture anymore."

The reversal in fortunes comes as emerging markets are enjoying what some analysts call a "Goldilocks" moment -- a combination of strong global growth, stabilizing commodity prices and improving domestic fundamentals. This has fueled a rally dwarfing gains made by U.S. stocks.

The MSCI Emerging Markets Index of stocks has risen around 28% this year, more than the 18% gained by the S&P 500, and is on pace for its best year since 2009. Currencies such as the Mexican peso and Russian ruble have risen this year and so have some developing-country government bonds.

More money is also flowing into the developing world. Investors will pour $1.1 trillion into emerging-market assets this year, the biggest flow of funds in three years, according to the Institute of International Finance. Flows are expected to increase further next year, to $1.2 trillion.

A rare spurt of synchronized global growth has been underpinning the rally. All 45 countries monitored by the Organization for Economic Cooperation and Development are on track to grow this year. That phenomenon has only occurred three times in the past 50 years, according to the OECD.

"Emerging markets can grow even if the Fed is hiking, provided that growth is playing ball. And right now, it is" said Stuart Sclater-Booth, emerging markets debt portfolio manager at Stone Harbor Investment Partners.

A rise in the price of raw materials has also boosted many exporters, with copper up 19% this year and Brent oil gaining 10%. The International Monetary Fund expects emerging economies as a whole to grow 4.9% in 2018, up from 4.6% this year, and more than double the growth rate in advanced economies.

But despite the supportive backdrop, many investors say the bigger change comes from within.

Back in 2013, emerging-markets assets swooned after then-Fed Chairman Ben Bernanke indicated that the central bank's bond-buying program might be wound down in an episode that became known as the "taper tantrum." Higher U.S. rates typically drive investors away from emerging markets by making their bonds, stocks and currencies less attractive.

This time around, in a year when the Fed has already raised interest rates twice and the European Central Bank indicated it will scale down its massive bond-buying program, there are few signs of stress.

"The Fed and other central banks matter less now because fundamentals have flipped," said Kevin Daly, portfolio manager for emerging market debt at Aberdeen Asset Management.


hat includes better governance and a drive by many countries in recent years to build up big foreign currency reserves and loosen their controls over exchange rates, allowing them to more easily absorb economic shocks, investors say.

"These aren't the same emerging markets we had 10 years ago," said Vasu Menon, senior investment strategist in wealth management at OCBC Bank in Singapore. "It's a different emerging-market investment universe," he added.

For investors like Ashok Bhatia, senior portfolio manager at Neuberger Berman, that means increasing exposure to some emerging-market assets. The firm earlier this year raised allocations in the dollar-denominated bonds of Brazil and Azerbaijan, believing they will be supported by higher commodity prices. It has also added to positions in the Peruvian sol.

History may also be on emerging-markets investors' side, too. Over the last four decades, the average emerging-market rally has run for 42 months and returned nearly 230%, according to a Bank of America Merrill Lynch analysis.

Still, risks remain, particularly if the Fed raises rates more aggressively than anticipated next year, the dollar strengthens or the Chinese economy wobbles. Recently, assets have wavered amid political and economic turmoil in key emerging markets like Turkey and South Africa, with the MSCI Emerging Markets Index broadly flat in the past three months.

Most investors assume the Fed's tightening path will be a gradual one, predicting two rate increases next year. The central bank, though, foresees at least three rate rises. Higher U.S. interest rates tend to strengthen the greenback, which is typically bad news for emerging markets, whose debt and commodity exports are often denominated in dollars.

"Markets believe central banks won't do anything too aggressive," Mr. Menon said. There is a risk "this quiet complacency is going to go out the window and that could reverse in a big way."

For now, though, the upswing is expected to continue unabated.

"There is an argument to be made that emerging markets have become 'crisis-proof,' " analysts at Citigroup wrote in a recent report. Barring any nasty shocks, developing nations "can stay in a Goldilocks zone."

Write to Georgi Kantchev at georgi.kantchev@wsj.com, Steven Russolillo at steven.russolillo@wsj.com and Ira Iosebashvili at ira.iosebashvili@wsj.com

(END) Dow Jones Newswires

December 11, 2017 05:44 ET (10:44 GMT)